This is a blog about interacting systems and how they behave: systems thinking construed broadly. Financial markets and economics; politics; and occasionally physical systems are discussed, with an attempt at focusing on how the rules of the game determine the strategies of participants and the possible outcomes.

Wednesday, 22 July 2009

39 Steps

No, not a (really rather good) novel by the 1st Baron Tweedsmuir, but rather the steps to revise IAS 39. For those of you who have not been following this slightly less gripping drama, this is the international accounting standard relating to the valuation of financial instruments.

The IAS 39 replacement project is proceeding in three phases:

Classification and measurement

Impairment methodology

Hedge accounting

We are at phase 1, but this is in many ways the most important one as it relates to the fundamental question what is a financial instrument worth?

The available for sale category is eliminated. All instruments are either held at fair value or amortised cost.

The treatment of embedded derivatives is simplified.

There will be only one approach to impairment, and it will be used for all instruments in the amortised cost category.

Only loan-like instruments can valued using amortised cost.

Much of the complexity of IAS 39 is eliminated, and the resulting accounting standard should be easier to apply.

The big problem, though, is the availability of amortised cost for some assets. Provided a financial asset is debt like, managed on a yield basis, and the institution's strategy is to hold it to maturity, then they will be able to use amortised cost accounting. This means that the ability to lie about what your assets are worth is preserved. It means that the same bond can be held at two different values by different institutions as one could use fair value and the other amortised cost. If a very firm approach is taken to impairment, and this approach is actually implemented by the audit firms, then perhaps this will not be a total disaster. But I still worry that the basic principle of true and fair has been obscured by the banks' desire to smooth earnings.

In their podcast -- even accountant standards setters make podcasts, -- the IASB say:

While fair value could provide useful additional information [for investors], the board believes that the cost of providing that information likely outweighs the benefits [in some cases].

I have to say that I don't share this belief. I think that the benefits of trying to estimate fair value are great both for the reader of financial statement and for the preparer. Of course, finding fair value can be as hard as finding an allicorn, and there can be considerable subjectivity in the process. But I still want to know what an institution estimates its assets are worth now, not what they might be worth if their strategy is successful.